CRS Enumerates "Shadow Banking" Risks

The Congressional Research Service ("CRS") identified issues and policy options related to the growth of "nonbank financial intermediation ("NBFI") or "shadow banking" entities that operate outside of the prudential regulation of the banking system.

The CRS highlighted the increasing size of these entities relative to banks, the vulnerabilities they present to financial stability and questions over the appropriateness of current regulatory frameworks.  The CRS explained that "total financial assets at [NBFIs] are more than 2.5 times that of the banks in the United States," and are involved in a wide range of activities affecting money market mutual funds, hedge funds, broker-dealers, structured finance vehicles and private lending markets.

The CRS identified NBFI risks—including (i) run vulnerabilities (notably during the 2008 financial crisis and the March 2020 COVID-19 market turmoil); (ii) leverage (particularly around hedge funds' use of borrowed money and derivatives which amplify exposures); (iii) liquidity mismatches (particularly in open-end funds and exchange-traded funds, where investors can redeem shares daily even when underlying assets are illiquid); (iv) concentration concerns (noting that the three largest asset managers control about 22% of the shares in the S&P 500 companies) and increasing interconnectedness with the banking system—that could pose systemic threats. The CRS warned that while regulators have good visibility into money market funds and mutual funds, blind spots remain around hedge funds, private equity and other less-regulated activities. 

The CRS stated that while banks are subject to prudential regulation emphasizing safety and soundness, NBFIs operate primarily under a disclosure-based capital markets framework. The CRS provided specific legislative and regulatory policy options for each identified risk but said that critics of applying additional regulation to NBFIs argue that imposing bank-like standards would be counterproductive.